Passive income — earning money without working for it – has an obvious appeal. But some passive income ideas seem like a waste of time to me. I do not believe I will earn income from them, they are not passive – or both.
One approach I do like though, is to invest in shares I reckon can pay me dividends in future. A dividend is a bit like a profit split – a company that has surplus cash can choose to pay some or all of it out to people who own its shares.
What’s so great about dividend shares?
Let me explain why I like this approach. With even a small amount, I can buy a stake in a large company like BP or Tesco that already has a proven business model and is profitable.
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Rather than reinventing the wheel with some wacky passive income idea, I can simply stake a claim on a piece of a wheel that is already turning smoothly – and profitably!
Some investing basics
Put like that, things sound very simple. Passive income does not need to be complicated.
Having said that though, I need to be conscious of the risks. I see two big ones when it comes to trying to earn passive income from buying shares.
One is that dividends are never guaranteed. A company can maintain its dividend for decades and then suddenly cut it, as Shell did in 2020.
Another is that shares can move up or down in price (sometimes even to zero). If I pay more for a share than it turns out to be worth, I may lose money over time, even if it pays me dividends.
An example of an income share
Having addressed some negative points, let me get back to the positive side of the ledger.
To spread my risk, I think it makes sense to diversify across a range of different shares. In stock market terms that is known as diversification. It basically means not putting all of your eggs in one basket.
How do I choose them? An example of a dividend share I would happily buy for my ISA right now if I had spare cash is Legal & General (LSE: LGEN).
The company operates in a market I expect to benefit from strong long-term customer demand.
Within that market, it benefits from some competitive advantages. The multi-coloured-umbrella brand is well known and has a long heritage, helping the firm attract and retain customers. Legal & General has a large customer base and deep expertise in the pensions field that might take newcomers decades to match.
On the other hand, this is a very competitive market and that can affect pricing, putting pressure on profit margins. If that happens, the dividend could be cut. Still, if I had spare cash to invest, I would happily buy Legal & General shares.
Aiming for a target
Rather than taking the dividends as passive income from day one though, I would reinvest them.
If I invested £200 each month and it compounded at 8.6% annually (the same as the Legal & General dividend yield, although well above the FTSE 100 average), after 20 years I would earn over £9,800 in passive income each year.
